Everything Lenders Need to Know About GSE Shareholders' Lawsuits

WASHINGTON – A powerful group of shareholders is amplifying attacks on housing finance reform legislation as they await resolution of a major legal battle, attempting to slow momentum on the bill before it likely passes the Senate Banking Committee.

Several big hedge funds that stand to possibly win billions of dollars for their shares in Fannie Mae and Freddie Mac are leading the charge, both in federal court and in the court of public opinion.

New investors’ rights groups said to be backed by the funds have popped up in recent weeks attacking legislation by Sens. Tim Johnson, D-S.D., chairman of the Senate Banking Committee, and Mike Crapo, the panel’s top Republican.

Their presence is yet another complicating factor in the tumult ahead of a scheduled April 29 vote by the committee, potentially hurting efforts to secure additional support for the measure.

“Now that different people have come out with their bills, it’s been laid bare that the people working on [government-sponsored enterprise] reform aren’t going to do major favors for the shareholders,” said Jeb Mason, a managing director at Cypress Group. “As a result, the shareholders have adjusted their strategy to muddy the waters – and, if they can, kill the Johnson-Crapo bill.”

Below we offer several frequently asked questions about these new groups, the pending court cases, and what’s at stake.

Why the sudden flurry of activity?

Detractors have stepped up their efforts in recent weeks because the Johnson-Crapo bill is headed toward a committee vote.

The legislation, which builds on earlier work by Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va., has already curried broad bipartisan support from members of the committee, but banking panel leaders will need to attract additional votes if the legislation is to have sufficient momentum to make it to the Senate floor this year.

Opponents are trying to raise questions about the need for reform and stress its impact on investors and the public in order to hurt that effort.

At issue is the Treasury Department’s treatment of Fannie and Freddie stock since the mortgage giants were put into conservatorship in the fall of 2008. The GSEs were initially required to pay 10% on the government’s stake each year, before Treasury altered the terms of the shareholders’ agreement in 2012, imposing a sweep on all company profits.

Shareholders, including those at big funds like Fairholme Capital Management and Perry Capital Management, argue that the government unfairly changed the terms of the agreement, tapping into returns due to junior preferred and common shareholders.

But recent legislative efforts aren’t proving any friendlier to shareholders.

The Johnson-Crapo bill codifies the profit sweep, known as the third amendment to the Senior Preferred Stock Purchase Agreement, and mandates that GSE profits be maximized for the government, which holds senior preferred shares. A rival House bill by Rep. Jeb Hensarling, R-Texas, chairman of the House Financial Services Committee, also codifies the provision.

By comparison, a discussion draft released by Rep. Maxine Waters, D-Calif., the ranking member on the panel, remains silent on the issue of the third amendment and includes a waterfall provision for the distribution of GSE profits, a decision that surprised some observers.

“The bill recognizes the need to create certainty during the transition from the old housing finance system to the new one. Therefore, it would codify a waterfall that would guide how Fannie Mae and Freddie Mac’s assets would be distributed upon their liquidation,” a Waters spokesman explained.

What have the shareholders been doing?

As part of their effort, investors have begun taking their concerns public through new tax-exempt groups in Washington. The investors argue they were on the receiving end of a rotten deal from the government, particularly those that bought the stocks before the enterprises were put into conservatorship.

“The hedge funds have this incredibly sophisticated, multi-pronged strategy – lawsuits, legislation, academics on the payroll, funding anonymous PR campaigns, offering to buy the companies. They’re coming at it from all angles,” said David Reiss, a professor at Brooklyn Law School.

It’s not entirely clear how or whether any of the individual efforts are coordinated, but the sheer number of groups forming, along with the sophistication of the initiatives, has led many observers to suspect that the big hedge funds, or perhaps wealthy backers of the funds, are involved to some degree.

Tracking the funding stream is difficult, however, because the groups are not required by law to disclose their donors. The groups have portrayed themselves as working for smaller investors like retirees, rather than for big hedge funds that mostly entered the market with speculative trades after the enterprises were in conservatorship and the stock prices had tanked.

“The hedge funds have likely realized they’re not doing themselves any favors by making millionaire money managers the face of the cause,” said Isaac Boltansky, an analyst at Compass Point Research & Trading. “Hedge funds are one of the least sympathetic groups on Capitol Hill.”

Can you name any of these groups?

The Coalition for Mortgage Security, led by Ken Blackwell, a former housing official under President George H. W. Bush, notes on its website that reform “must benefit and treat fairly current and future homeowners, taxpayers, and investors across the country.”

The group says it promotes replacing the GSEs with private companies and protecting the 30-year mortgage, while also reiterating concerns about ongoing shareholder claims.

“The rule of law is the basis for American capitalism and must be acknowledged and respected in order for properly functioning capital markets,” the website says. “This is the cornerstone for attracting private capital to any market, especially the housing finance market. The rules of the game cannot be changed in the middle of an inning.”

A second group, Investors Unite, led by Tim Pagliara, a former investment manager, has also come onto the scene in recent weeks, pushing instead for the recapitalization of the mortgage giants, including the return of affordable housing goals.